The Best Tax Move To Shelter Property

By Robert Milburn

Investors in highly-appreciated multifamily homes or commercial office buildings can cash out without incurring a hefty tax bill. A 1031 Exchange is an IRS-sanctioned rule that allows investors to sell a property and buy another “like” property without incurring capital gains taxes. There are a few wrinkles, of course, but when coupled with smart tax and estate planning moves, it can be a remarkably effective way to transfer wealth.

Here’s how it works. Suppose an investor bought a multifamily home 40 years ago for $1 million. For tax purposes, the home’s value was depreciated over time so that today’s cost basis is zero. Now, if the property’s value had skyrocketed to $5 million, then at the time of the sale, the owner would be forced to pay $1.2 million in taxes (at the top federal capital gains rate of 23.8%). By using a 1031 exchange, the investor could sell off the property and use the proceeds to buy another $5 million property and defer the taxes.

That’s a useful tool. Using 1031 exchanges, savvy investors can continually roll money from overvalued property to undervalued properties, or, for older wealthy folks looking for cash flow, simply transfer money to a building in a better neighborhood that fetches a higher rent. With an index of commercial and residential properties surging more than 90% since bottoming six years ago, according to real estate research firm Green Street Advisors, 1031 exchanges are on the rise. A National Association of Realtors survey found that 63% of the nearly 3,500 developers and real estate brokers questioned had participated in an exchange between 2011 and 2015.

The rules around 1031 exchanges are fairly clear. Both properties, the one being sold and the newly acquired, have to be for investment purposes or for “use in a trade or business,” which essentially means it is rented out to tenants. A second home doesn’t qualify for the exchanges, unless it’s rented out for at least 14 days a year and the homeowner doesn’t live in it for more than 14 days each year, says William Siegel attorney at Greenberg Traurig. The newly-purchased building must also be a “like” property, a rule that is surprisingly loose. Investors can exchange combinations of multifamily rental, commercial property or even vacant land.

At the sale of the old property, be careful not to run afoul of the regulations. After the date of the original property’s sale, an investor has 45 days to identify a new acquisition and the deal must close in 180 days. And don’t simply collect the cash from the original sale; investors must use a “qualified intermediary” to hold the money in escrow. The intermediary will transfer the proceeds for the new buy. (Qualified intermediaries include Investment Property Exchange Services, or specialized units at banks like Wells Fargo.) Also note: If the newly-purchased property is worth less than the one already sold, investors must pay capital gains on the difference.

Where the building has appreciated to $5 million, at their parent’s death, the beneficiaries could in theory get the $5 million market value tax-free, because it is below the lifetime gift exclusion of $5.4 million per person. “If that’s your biggest asset then [using up the exemption] is not an issue for the family,” Trotta says. If the heirs are also inheriting a business or other valuable assets, then of course careful estate planning, well before the transfer takes place, should take place. For more ideas on sheltering a business interest from costly taxes, see “Silicon Valley: Protecting IPO Windfalls With a Trust.”

About Penta

Written with Barron’s wit and often contrarian perspective, Penta provides the affluent with advice on how to navigate the world of wealth management, how to make savvy acquisitions ranging from vintage watches to second homes, and how to smartly manage family dynamics.

Richard C. Morais, Penta’s editor, was Forbes magazine’s longest serving foreign correspondent, has won multiple Business Journalist Of The Year Awards, and is the author of two novels: The Hundred-Foot Journey and Buddhaland, Brooklyn. Sonia Talati is Penta’s reporter about town, both online and for the magazine. She previously worked for the Wall Street Journal and various television station affiliates around the country. Sonia has a B.A. in economics from the University of California, Los Angeles, and an M.A. from Columbia University Graduate School of Journalism.